A Silver Lining for Bond ETF Investors

By Jonnelle Marte

This year through June, investors added $32 billion to domestic bond ETFs, up 60% from the same period last year and on pace to surpass last year’s inflows of $45 billion, according to fund researcher Lipper. Fixed-income ETFs now account for 8% of the assets in the bond mutual fund market, up from 6% at the end of 2010.

Experts say this growth comes as investors continue to flee stocks for the perceived safety of bonds. But bond ETFs’ lower cost make them especially appealing as payouts on most types of bonds are near record lows, says Todd Rosenbluth, a mutual fund analyst for S&P Capital IQ. (The yield on the 10-year Treasury fell below 1.5% on Wednesday.) “Given how low yields are, every dollar you spend on a mutual fund or commission adds up,” says Rosenbluth.

Consider: the $15 billion iShares iBoxx High Yield Corporate Bond ETF (HYG) charges 0.50%, or $50 for every $10,000 invested, compared to an average expense ratio of 1.2% for all high-yield mutual funds. And the $260 billion Pimco Total Return fund (PTTAX), charges 0.85%, while the ETF version launched last year — the $1.9 billion Pimco Total Return ETF (BOND) — charges 0.59%. Over 20 years, someone investing $10,000 in the ETF could save more than $1,100 in fees and expenses.

As more bond ETFs hit the market, investors are also using the funds to invest in specific portions of the bond market that aren’t as easily targeted through mutual funds, says Timothy Strauts, an ETF analyst for Morningstar. There are about 220 bond ETFs available today, compared to less than 50 in 2007, according to Cerulli Associates. Some track certain corporate bond sectors like utilities and industrials, and while others only invest in specific credit qualities. “You can tailor your exposure,” says Strauts.

There are risks. Bond ETFs can often trade at a price above or below the value of the underlying holdings, meaning some investors end up paying more for the funds than the portfolios are worth—or selling their shares at a discount. Some retail investors may also be better off using broader diversified mutual funds, instead of narrowly targeted ETFs, which can be more volatile, say advisers.

Still, many experts expect the popularity of bond ETFs to explode in coming years. (The biggest seller of ETFs, BlackRock’s iShares, estimates assets in U.S. bond ETFs could reach $1.4 trillion over the next decade, seven times today’s $222 billion). As bond ETFs establish longer track records – most funds don’t go back more than five years – analysts say they’ll likely attract more investors. “It is conceivable bond ETF assets will grow at a faster rate than stock ETFs,” says Rosenbluth.

The reason the bond ETFs are being bought is because of the bond price increase due to yields dropping. Yields can’t go much lower so when the yields start to rise the bond prices will drop and people will sell them off so need to watch the trend.

Search Real-Time Advice20

About Real-Time Advice

How breaking news — in the markets, Washington, and around the world — affects you and your money. Have a question about how current events may change your financial future? Email us at ask@smartmoney.com.